Silicon Bubbly?

Once upon a time, unicorns were mythical creatures that popped up occasionally in fairy tales and Harry Potter. Now they are privately held tech firms—too mature to be called startups—with market valuations of $1 billion or more. Some estimate 100 of these tech unicorns exist, including a few “decacorns”[i] valued at $10 billion, leading many to wonder whether their value is real or as mythical as their namesakes. “Tech bubble” fears abound, drawing comparisons with the go-go late 1990s and the bloody aftermath that followed. And hey, perhaps there is some froth in Silicon Valley. But either way, if you must look this far outside of equity markets for a bubble, that is a good sign stocks themselves aren’t bubbly.

Whether Silicon Valley’s private equity scene is a bubble is impossible to prove definitively. Venture capital luminaries are fairly divided on the matter, though for what it’s worth, they aren’t as angst-ridden on the topic as some pundits are. To determine whether companies are overvalued, you must have reliable data—sales, profits, balance sheets and the like. Some privately held firms report some of this information, but shareholder reporting isn’t required until they have 2,000 shareholders. For most firms, you can’t just visit their websites, hop on their investor relations pages, and see how they’re doing. Their value is hard to pin down, too. For all the talk of “So and so just raised new funding that values the whole company at such and such,” a lot of that is accounting smoke and mirrors. It isn’t transparent. It isn’t even the broad market’s judgment of value. A lot of these deals are constructed specifically to give these firms unicorn status, because it is cool to be a unicorn.[ii]

So from that perspective, we understand the temptation to say, “Hey! These guys are valued based on feelings and hopes! BUBBLE!” There are some other signs of potential froth, like the fact many of the late-stage investors signing on to these billion-dollar-plus valuations are hedge funds and equity mutual funds, not venture capital firms. There is a strong sense on Wall Street and in the City of London that to get any real return in this environment, you must own early-stage firms and wait for a big payoff. It isn’t true, but it sells well and attracts investors, so, you know. And when you try to reconcile funds’ enthusiasm with the fact that many IPOs fizzle over time, it does seem like sentiment is out of step with the likely reality.

At the same time, though, for any of this to really impact investors and capital markets, there would have to be some severe financial damage if these unicorns were discovered to be mere horses or zebras or whatever.[iii] We’ve mentioned before that it usually takes a few trillion of deleted capital or economic activity to cause a bear market, and a correction in private equity valuations alone wouldn’t come close. Billions, perhaps, but not even close to $1 trillion. Yes, on the surface, if an, um, über startup with a $50 billion valuation turned out to be worth just a couple billion, that might seem like tens of billions in potential losses. But it’s really just the deletion of hopes and dreams. This was the conclusion in a recent report from Fenwick and West, which analyzed the terms of 37 firms’ unicorn funding rounds during the year ending 3/31/2015. Among their findings:

Investors in unicorn financings have significantly more downside protection than public company common stock investors. These protections are especially strong in the event of an acquisition. For example, CB Insights reported that the 10 highest valued unicorns had an aggregate valuation of $122 billion and an aggregate invested capital of $12 billion. Since 100% of the unicorn financings had a liquidation preference, valuations of these companies could fall on average by 90% before the unicorn investors would suffer a loss of their investment, and they could withstand an even greater decline if they had a senior liquidation preference over other series of preferred stock.

That’s more of an “aw shucks” than a “look out below.” Plus, we’d be remiss not to mention that a lot of these unicorns have been around for years. They aren’t fly-by-night operations. At a recent conference, venture capital titan John Doerr pointed out that the average length of time from founding to IPO has jumped from about four years in the 1990s to about eight years today. Sarbanes-Oxley made going public far more burdensome than it used to be, and if firms can get funding when private, there is little point in going through the hassle of tapping the public. Most of these firms, by the way, have actual business plans, customers and proven revenue streams. “Clicks are the new profits” is soooooooooo 1999.

Anyway, we guess the main takeaway here is, if you’re eyeing any funds that have hopped on the unicorn bandwagon, do your homework and know what you’re getting into, and stay diversified. But if you’re looking for evidence of lurking troubles in publicly traded stocks, you won’t find it in the venture capital scene.[iv]

[i] Ugh. Yes it’s a thing, unfortunately. Though we’re hard-pressed to come up with a better word.